Tuesday, March 30, 2010

Position sizing

One of the most important subjects in trading is position sizing, yet it is very difficult to find more information on it and to have quick and magic formula. A position sizing should tell you how much of a position to take based on your account size or, if you look it from our side of trading ALSI contract, how much one must have per contract traded.

My opinion is that for traders who made it to the next level of trading and who are constantly making money, the most dangerous is to trade with too big positions, as that could cause them to go belly up.

On the other hand, risking too little will prevent growth at speed desired. One should try to find very thin line between destroying his account when system gets into drawdown on one side and trading large enough in order for progress to materialize and for his account to grow.

So, what is the solution for this? How can we determine how much should we trade?

Some books say that one should not risk more than 1% of the equity on any trade. This rule was made for share trading/investing with no leverage added. My opinion is that this rule must be modified to 5% per trade for valid, sound, well-tested systems. So, what does that mean?

Let’s say we trade ALSI contract and average loser is 300 points. If you don’t want to risk more than 5% per trade, then you need to have at least 6000 points in account. So, if you trade one contract and average loser is R3.000, then I would recommend having at least R60.000 in your account. This will give you approximate chance to comfortably survive even 2500 points drawdown and have money to continue trading.

Another approach to measure position sizing is based on Kelly formula which was used by famous Turtle traders:

The Kelly's formula: Kelly % = W - (1-W)/R

where:

Kelly % = percentage of capital to be put into a single trade.

W = Historical winning percentage of a trading system.

R = Historical Average Win/Loss ratio.

Third approach is Optimal F formula which is small modification of Kelly’s work. I’ve found out about this formula from http://www.verticalsolutions.com/

Optimal F is maximum number of contracts one can trade for given account size. One should never trade more than optimal F suggests, because risk of destroying account is growing, but one can and probably should trade fewer contracts than optimal F suggests.

Optimal F formula: F = (Largest losing Trade)/((((1+win/loss ratio)*% wins)-1)/win/loss ratio)

One of the drawbacks of the Optimal F formula is that Largest losing trade is not fixed number and it could be changed in any time. Unfortunately, in trading there are few if any determined values, so one must live with it if one wants to use this formula. For most of our systems we are using this formula and for system published on twitter formula says that one must have R25.000 on top of the margin to trade one contract or R42.000 per contract with margin of R17.000.

As a side note for folks who like Optimal F – If you have tested your system over long period of time, but you have discovered later that your system was tested with data when Average True Range (or any other adequate volatility measure) was, let’s say, 2-4 times smaller than present volatility level, I would strongly suggest for exposure to be cut 2-4 times, as big loser (which will change Optimal F value) is just around the corner.

Also, from my experience, having in mind an assumption that your systems are robust, well tested and executed, I would suggest trading with 30–100% extra (in account per contract traded) over Optimal F value, subject to black swan events; robustness of your system and faith you have in your own research, and market conditions.

Last approach that I know of is Van Tharp’s approach from one of his books where he says that in account one must always have double the amount of known maximum drawdown (for the system) on top of the margin. For our average systems drawdown is between 2000 and 2500 points. So, that comes again to 5000 points plus margin for each contract traded.

Obviously, there is no magic formula that will tell you how much one must risk in every trade. There are four different calculations in this post and decision must be made according to risk profile of each trader. One must be very careful with how he handles money, because when money is gone the game is over, but again, one should not be too conservative because then there is no need to trade highly geared instruments like futures.

This subject is never ending story and the more we trade the more we will find what our optimal position sizing is. In some instances, when markets perform better or volatility is low, one can increase size or do the opposite when market conditions do not favor one’s systems. But again, this can and will come only with experience and for the start one should just stick to what is explained above.

Trade with trend!


9 comments:

MadMan said...

Nice post Icko! As it turns out, 5% is the result of the Kelly formula with system R=2 and W=0.4, which is typical for a good trend following system, then halved for good measure. Over leverage hurts much more than under leverage, and you may have over estimated your system performance, so using 0.5Kelly is a good rule of thumb

Alsi Trader said...

Thank you MadMan.

Anonymous said...

Such a nice and comprehensive post.

The best post that I saw on the topic on the net so far!

Thank you.

Alsi Trader said...

Thank you Anonymous for your kind words.

Anonymous said...

Brilliant post!

Alsi Trader said...

Thank you very much.

Will try to keep it up and share.

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